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May 2, 2014

PIMCO’s Gross: Pop Your Bubble Fears!

Because a levered economy depends on low rates, which the Fed will deliver, investment assets should be more fairly priced than bears assume

PIMCO bond manager Bill Gross says current fears of an asset bubble are "unfounded" and that stocks, bonds and real estate have room to run.

In his May monthly investment outlook, the manager of the world’s largest bond fund says “investors could draw some comfort from a low-returning yet less volatile future.”

The basis for this reassurance derives from the academic debate, which Gross reviews, swirling over what is the correct long-term neutral policy rate, which “forward markets” anticipate at 4%, but which Gross, citing multiple studies, pegs at close to 2%.

“If the neutral policy rate was 2% instead of 4% then bonds, instead of being artificially priced, would be attractively priced,” Gross writes, adding:

“Bonds would shed the ‘certificates of confiscation’ label for yet another decade or so, as this 2% neutral policy rate delevered the economy without igniting inflationary fears.”

The delevering is key to understanding the significance of this debate. Fed monetary tightening a decade ago was based on a standard application of the so-called Taylor Rule that seeks to make credit more costly in order to stem inflation. What the Fed of that time failed to grasp was that the economy had become so leveraged that it could no longer function under that model.

As Gross puts it:

“Interest rates have to be lower in a levered economy so that debtors can survive, debt can be reduced as a percent of GDP, and economies can avoid recessions/depressions!”

A 4% rate would assure a half-decade-long bear market, which the Fed is assiduously working to avoid, Gross argues, adding that the resulting financial repression comes at the price of reduced future returns: “potentially 2% instad of 4% for cash; maybe 3% instead of 5% yields for 10-year Treasury bonds; 4% returns instead of 5%-7% for stocks,” he writes.

Gross also offers a warning for pension funds that typically assume high rates of return in the 7%-8% range.

“Investors want their ‘cake,’ priced at current market prices, but they want to ‘eat’ future returns of near double-digits," he writes. "That won’t happen with a 2% neutral policy rate.”

The bond manager offers PIMCO investors the assurance that its managers know how to “fight back” through alternative risk strategies that can boost returns in this environment.

Specifically, Gross mentions “alternative assets, hedge funds, levered closed-end funds, a higher proportion of stocks versus bonds in a personal portfolio” as ways astute managers can eke out better returns “in a world of 2% policy rates where cash is a poor performing asset, but likewise a cheap liability that can be borrowed to an investor’s advantage.”

The plug for PIMCO managers comes at a time when the fund giant has struggled to retain the loyalty of shareholders after Gross’ Pimco Total Return Fund lost 1.9% in 2013.

Reuters reports that investors in the flagship bond fund withdrew $3.1 billion in April, the 12th consecutive month of outflows, bringing annual net losses from last May in excess of $55 billion. That hemorrhaging has reduced assets under management from a high of $293 billion in April 2013 to its current $230 billion level.

Gross’ current view that Treasury bonds specifically and investment assets generally are attractively priced at the 2% neutral rate he imputes over the balance of the decade is more bullish than the view he expressed just two months ago.

At that time, he wrote that 2014 should be a positive year for investors, though possibly the last positive year in the current era of quantitative easing.

Specifically, he warned that Fed tapering would eventually threaten corporate bonds and a reemergence of inflation would make current pricing unattractive.

If “the longevity and effectiveness of that artificially low policy rate comes into question,” Gross wrote in March, “then the center…may not hold.” The key challenge for investment managers would then be timing their exit from the market.